A Roth IRA conversion is when you convert money from a Traditional IRA into a Roth IRA. Why would you want to convert to a Roth IRA? Because depending on your financial and tax situation, Roth IRAs have advantages over Traditional IRAs due to how and when the funds are taxed.
When you complete a Roth IRA conversion and rollover funds from a Traditional IRA into a Roth IRA, the amount of money rolled over is added to your taxable income for the year. Essentially, you’re paying taxes now on the current value of the funds so that your future distributions will be nontaxable.
Who Should Consider a Roth IRA Conversion
A Roth IRA conversion makes sense for investors who are in a lower tax bracket than they expect to be when they retire. On the other hand, if you are already in a higher tax bracket and expect to remain in that tax bracket or perhaps even be in a lower tax bracket by the time you retire – then a Roth IRA conversion may not be a good financial decision for you.
A good time to convert to a Roth IRA is when your Traditional IRA has less value – like during troubled economic times – because you will make your current taxable amount smaller.
How to Set Up a Roth IRA Conversion
You will need to open a Roth IRA before you make the conversion (you may be able to do both at the same time, depending on where you open your Roth IRA). There are two options for executing a Roth IRA conversion; rollover or transfer.
- Rollover – if you choose the rollover option, you can choose to take a distribution of funds from your Traditional IRA and “roll it over” into a Roth IRA within 60 days.
- Transfer – if you choose the transfer option, you can simply tell the broker or bank that holds the Traditional IRA to transfer the money directly to your Roth IRA.
Regardless of the option you use to convert to a Roth IRA, you must move the entire amount of money you get from the Traditional IRA into your Roth IRA. Do not keep the cash or do anything else with any of the money or you will be penalized with an early withdrawal penalty and income tax penalties.
Roth IRA Conversion Eligibility
There are a few eligibility requirements you must meet to convert a Traditional IRA to a Roth IRA, including:
- If you are over the age of 70 and a half years and receiving minimum distributions from the Traditional IRA, you are not allowed to roll over those distributions into the Roth IRA.
- Your income tax filing status cannot be “married filing separately” unless you didn’t live with your spouse for an entire year, then you may still be eligible if you meet the other requirements.
- If you inherited an IRA from someone other than a spouse, it cannot be converted from a Traditional IRA to a Roth IRA.
Should you do a Roth IRA Conversion?
There are many factors that can complicate Roth IRA conversions, so it is a good idea to look at the total situation including your current financial position, current tax rates, potential future tax rates, and other issues. You may also find it a good idea to consider hiring a financial advisor or hiring an accountant for assistance with this decision.
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